Six Best and Worst IRA Rollover Decisions

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1 Six Best and Worst IRA Rollover Decisions Provided to you by: Daniel R Chen x101 FPA

2 Six Best and Worst IRA Rollover Decisions Written by Financial Educators Presented by Daniel R Chen x101 FPA Securities and Advisory services offered through Cetera Advisors LLC, Member FINRA/SIPC. Cetera is under separate ownership from any other entity. No investment strategy can eliminate the risk of fluctuating prices and uncertain returns Update v.2.0

3 Six Best and Worst IRA Rollover Decisions (When You Retire or Change Jobs) IRA owners and their advisors can make expensive mistakes handling IRA rollovers. These mistakes range from the simple to the complex. A simple mistake occurs when an employee takes a check when they retire and their employer must withhold 20%. In order to complete a tax-free rollover, the IRA owner needs to replace the 20% withheld by their employer using their own funds to meet the tax-free rollover requirement within 60 days (more on this later).1 Then there's the more complex mistake the advisor who does not realize that his client was born prior to 1/2/36 and qualifies for 10-year averaging. The tax on the funds would potentially be 20% using averaging, but may be as much as 35% if a normal rollover is completed.2 Read on for the dos and don'ts of handling IRAs. Best Decisions 1. Leave money in the qualified plan if retiring between ages 55 and 59½ and distributions are required. Since there is no penalty on withdrawals from a qualified plan after attainment of age 55 and separation from service (age 50 for qualified public safety employees), distributions are more liberal than if funds are rolled to an IRA.3 Once funds are rolled to an IRA, there is generally a penalty for withdrawals prior to age 59½. Therefore, it's best for people who need money from their retirement account in this age bracket to leave the money as is, in their company retirement plan. Often, people who have already completed their rollover are younger than age 59½ and need a distribution. In these cases, they can use rule 72t to avoid penalties. When they do this, it's best to split the IRA into pieces for maximum benefit. Each IRA stands on its own, which means that taking 72(t) distributions from one account has no effect on the others. Therefore, if one IRA produces more income than is needed when placed on 72(t) distributions, you could split the IRA into more than one account, and use one of the smaller accounts to make your withdrawals. And in the future, if you need more income, you could begin equal distributions from another account as well. This could provide greater flexibility in meeting your immediate and future income requirements if under age 59½.4 2. Make optimal use of creditor protection Some IRA owners and financial advisors think that the recent changes to the federal bankruptcy rules automatically protect IRAs. That is not true. For creditor protection purposes, it's best for an individual to leave his funds in a qualified plan because ERISA gives complete creditor protection to qualified plans (note that one person qualified plans do not receive the protection there needs to be at least one "real" employee in the plan). If the individual does roll over his qualified plan into an IRA, it is optimal to leave these funds in a separate rollover IRA, because the protection that the funds had under ERISA will follow the funds into the rollover IRA. 1 IRS Publication IRS publication Ibid. 4 Once rule 72t is selected, distributions must be taken for at least five years on that schedule or until age 59½, whichever is later. Failure to complete the schedule will result in a 10% penalty on prior withdrawals. 3

4 According to the Supreme Court, IRAs are creditor protected to the extent reasonably necessary for your support. In the case of people with other assets, it is unwise to rely on the Courts decision.5 Individuals may in fact have protection under the federal bankruptcy laws or their state's rules addressed below. Unfortunately, the protection one has is not always clear. Not all states actually use the federal bankruptcy exemptions. In fact, some have state level bankruptcy exemptions. Consequently, in some states, the exemptions must be used; in other states, the individuals have the choice of federal or state exemptions, and only in the remaining states must the federal statutes be used. Consequently, the Supreme Court's decision will only apply in states where the individual has a choice between state and federal exemptions and chooses the federal exemptions, or in states where the federal rules must apply. ERISA protection provided to money in a qualified plan [401(k), etc] universally pre-empts state law and always provides creditor protection. It's also unclear whether the ruling will apply to Roth IRAs, which have far fewer age-based restrictions (since contributions can be withdrawn penalty-free at any time, and no required minimum distributions apply during lifetime). Therefore, Roth IRAs would not meet the three-prong test evaluated by the Supreme Court in the Rousey decision. Consequently, decisions to complete IRA rollovers from ERISA-protected retirement plans must still be made carefully. Be aware that when you roll assets from a company plan to an IRA, you may lose creditor protection, so it is wise to check with legal counsel. 3. Re-Check Your Beneficiaries A company retirement plan (a qualified plan) is governed by the ERISA rules. And those rules state that you must name your spouse as a beneficiary or get spousal consent to name another person. The same rules do not apply to IRAs. Therefore, in creating your rollover account, you have the flexibility to name the beneficiaries you desire. Additionally, always name contingent beneficiaries in the event your primary beneficiary predeceases you. Here are some examples, and you may want to check with an estate planner to finalize your selections: a. Name your spouse as primary beneficiary and your children as contingent beneficiaries. In this situation, your spouse will inherit your IRA if he or she survives you. The children get none of the account. If your spouse predeceases you, your children inherit the IRA. Carefully consider if the beneficiaries have the capacity to manage potentially large sums of inherited money. If not, you may want to consider an IRA Asset Will or IRA Trust. b. Name your children as primary beneficiaries. They will inherit your IRA. If there are any adverse relationship issues between your children, you may want to have the IRA split so that each account goes to one child and nothing needs to be split among the children. c. Name anyone you desire. Beneficiaries do not need to be relatives. Remember this all important rule whoever you name as beneficiaries on your IRA account will inherit your IRA. Your will or living trust has no control over your IRA, so make sure your IRA beneficiaries are exactly as you desire. 5 Rousey v. Jacoway ( ). 4

5 Worst Decisions 1. Get a check from the company Of course, this is just foolish. The company must withhold 20% from the payment, so that a person with a $100,000 account will have $20,000 withheld, and will receive a check for $80,000. In order to complete a tax-free rollover, the taxpayer must deposit that $80,000 in an IRA plus $20,000 from their pocket to complete a tax-free $100,000 rollover. The taxpayer may eventually get the $20,000 withheld as a tax refund the following year, but that will not help their cash flow, as they need to complete their IRA rollover within 60 days of receiving the check from their qualified plan. The bottom line is that people should never touch their qualified funds. The only sensible way to move funds is a direct transfer from the qualified plan to the IRA custodian and avoid withholding. 2. Rollover company stock Shares of employer stock get special tax treatment and, in many cases, it may be fine to ignore this special status and roll the shares to an IRA. This would be true when the amount of employer stock is small, or the basis of the shares is high relative to the current market value. However, in the case of large amounts of shares or low basis, it would be a very costly mistake not to use the Net Unrealized Appreciation (NUA) Rules.6 If your company retirement account includes highly appreciated company stock, an option is to withdraw the stock, pay tax on it now, and roll the balance of the plan assets to an IRA. This way you will pay no current tax on the Net Unrealized Appreciation (NUA), or on the amount rolled over to the IRA. The only tax you pay now would be on the cost of the stock (the basis) when acquired by the plan. If you withdraw the stock and are under 55 years old, you have to pay a 10% penalty (the penalty is only applied to the amount that is taxable). IRA owners can then defer the tax on the NUA until they sell the stock. When you do sell, you will only pay tax at the current capital gains rate. To qualify for the tax deferral on NUA, the distribution must be a lump-sum distribution, meaning that all of the employer's stock in your plan account must be distributed. 6 IRS Publication

6 Hypothetical Example Jackie just retired and has company stock in her profit sharing plan. The cost of the stock was $200,000 when acquired in her account, and is now worth $1 million. If she were to rollover the $1 million to her IRA, the money would grow tax-deferred until she took distributions. At that time, the withdrawals would be taxed as ordinary income (up to 35% federal). When Jackie dies, her beneficiaries would pay ordinary income tax on all of the money they receive. But if Jackie withdrew the stock from the plan rather than rolling it into her IRA, her tax situation would be different. She would have to pay ordinary income tax on the $200,000 basis. However, the $800,000 would not be currently taxable. And she would not have to worry about required minimum distributions on the shares. If she eventually sells the stock, she would pay the lower capital gains tax on the NUA and any additional appreciation. Jackie's beneficiaries would not receive a step-up-in-basis for the NUA. However, they would only pay at the capital gains rate. Appreciation between the distribution date and the date of death would receive a step-up-in-basis (based on tax rules in effect in 2009); therefore would pass income tax-free. With NUA Without NUA 35% Tax on $200,000 $70,000 35% Tax on $1 million $350,000 15% Tax on $800,000 $120,000 Total Tax $190,000 $350,000 Let's assume the stock value increases to $1.5 million in five years, and she decides to sell. Taxable Amount Tax Rate Potential Income Tax to Jackie Plus Amount Previously Paid Total Tax With NUA $1.3 million 15% $195,000 $70,000 $265,000 Without NUA $1.5 million 35% $525,000 Finally, assume that Jackie died in five years after the stock increased to $1.5 million. What would her beneficiaries have to pay? Taxable Amount $800,000 With NUA Without NUA $1.5 million Tax Rate 15% 35% Income Tax $120,000 $525,000 Amount Receiving Step-Up in Basis $500,000* 0 *Because 2010 is a transition year with estate taxes, there is a limit on the step up in basis of $1.3 million for capital gains. 6

7 3. Rollover after-tax dollars Sometimes, qualified plan accounts contain after-tax dollars. At the time of rollover, it is preferable to remove these after-tax dollars, and not roll them to an IRA. That way, if the account owner chooses to use the after-tax dollars, he will have total liquidity to do so. You can take out all of the after-tax contributions, tax-free, before rolling the qualified plan dollars to an IRA. You also have the option to rollover pre-tax and after-tax funds from a qualified plan to an IRA and allow all the money to continue to grow tax-deferred. The big question is, "will you need the money soon?" If so, it probably will not pay to rollover the after-tax money to an IRA, because once you roll over after-tax money to an IRA, you cannot withdraw it tax-free. The after-tax funds become part of the IRA, and any withdrawals from the IRA are subject to the "Pro Rata Rule." The Pro Rata Rule requires that each distribution from an IRA contain a proportionate amount of both the taxable and non-taxable amounts in the account. The non-taxable amounts are called "basis." In an IRA, the basis is the amount of non-deductible contributions made to the IRA. Example Paula has $100,000 in an IRA; $20,000 is the basis (the total of her non-deductible contributions made over the years). She rolls over $200,000 from her former employer's plan to the IRA, of which $10,000 is from after-tax contributions. After the rollover, she'll have $300,000 in her IRA. The basis becomes $30,000 (the $20,000 nondeductible plus the $10,000 of after-tax funds rolled into the IRA = $30,000 basis). Now Paula wants to withdraw $10,000 of after-tax money from the IRA, figuring it will be tax-free. It will not. Only $1,000 of the withdrawal will be tax-free. She will pay tax on the other $9,000. The Pro Rata Rule requires each withdrawal contain a proportionate amount of both taxable and non-taxable funds. Therefore, the non-taxable amount in the IRA is $30,000, and that is 10% of the total $300,000 IRA balance after the rollover. This means that each withdrawal will be 10% tax-free and 90% taxable. Another option is to convert Paula's entire $300,000 IRA to a Roth IRA (assuming she otherwise qualifies for the conversion). Then all withdrawals will be tax-free. She will pay tax on $270,000; the $30,000 of basis will transfer tax-free to the Roth IRA. A partial conversion will require the use of the Pro Rata Rule. The seemingly simple task of rolling over money from a company plan to an IRA bears many complicated decisions. If talking with a professional would be of value, we welcome your questions. 7

8 About Daniel R Chen x101 A resident of the Monmouth County area since 1968, Daniel Chen is a graduate of Monmouth University, West Long Branch, with a BS in Psychology. Dan currently provides Wealth Management services in the four specific disciplines of Estate Planning, Risk Management, Tax Efficient Strategies, and Investment Management services via the financial planning process. His twenty years as a trader in the U.S. Treasury markets for firms including Garban LLC and Cantor Fitzgerald has provided him with an immense and diverse experience in the global capital markets. In 1999 Dan recognized the need for personalized investment advice by employees of the small business pension plan market. As a result he set about crafting a solution for this underserved population which became well received by the major stakeholders of the small business community. In recognizing the scarcity of the independent advice and research service model, he set upon designing and implementing the delivery of an individually personalized and high touch investment management process to the demands of an increasing affluent clientele marketplace. Dan is currently listed as a rated advisor in the Paladin Registry, an independent non bias third party registry that pre-screens and qualifies advisors according to their business ethics and credentials. Please go to the following link: to view his profile in greater detail. Today Dan serves a growing clientele base via a consultive process in defining and creating sound strategies for achieving their wealth management and preservation goals while collaborating with their other key advisors [i.e.; accountants and attorneys]. In addition, Dan holds insurance and securities licenses administered by FINRA and the N.J. State Department of Banking & Insurance [i.e.; Series 6,7,24 and 63]. He is also a member of the Financial Planning Association and an Associate Registered Investment Advisor (RIA) with Multi-Financial Corporation. 8

9 About Daniel Chen Assisting clients in understanding where they are today can be critical in setting attainable financial and personal goals for the future. We know your hopes and dreams include sending your children to the right schools, a comfortable retirement, and financial security late in life. We are a Wealth Management firm assisting our clients in negotiating the financial barriers that invitably arise in every stage of life. Our team has the experience to help you persue these important goals. Ultimately, our greatest impact may be the confidence that comes with working with an Advisor that will educate his clients in the options that are available,and implement those strategies in simple and easy to understand terms. Phone today with questions or to see if we can help you. There is no charge for an initial meeting. Daniel R Chen x101 FPA Daniel Chen 12 Christopher Way Suite #200 Eatontown, NJ x101 9

10 2010 Financial Educators First Published 9/5/08 This booklet is protected by copyright laws. It may not be reproduced or distributed without express written permission of the author. Published by Financial Educators 10